Portfolio construction is one of the most important things
to get right in equity investing but also one of the hardest. While the asset
selection part of investing is fairly obvious (buy assets you believe to be
undervalued or assets you expect to increase in price) just very hard to do
consistently, portfolio construction is far more subtle. One of the issues that
always causes a big debate is what is the right level of diversification for an
investor.
Making this decision isn't helped by the fact that we get
very different advice from different people. For example, Warren Buffet has called
diversification ‘diworsification’ and suggested that most people be better off
investing their money in their few best ideas. He introduced a concept of a 20
punch hole card representing the 20 investments one can make in one’s lifetime
as a way of improving investors’ stock selection. At the other extreme ‘quants’
will own hundreds of stocks and index investors like Jack Bogle believe that
the only correct level of diversification is owning the whole market. Even more
confusing is that both sets of investors, and a lot of people in between, have
good evidence to support their view. Given the breadth and strength of views
that exist on the subject of diversification I think we often make the
following key mistakes when thinking about the topic:
- Viewing the right choice of diversification as independent of one's style of investing and fixed in time. i.e. what is right for me now is always right for me and must be right for you.
- Ignoring risk in portfolio construction decisions.
Principle 1 - Diversification levels should increase as
uncertainty increases.
This means that all things being equal beginners should have
a higher diversification level than experienced investors who have a track
record of being able to consistently identify mis-priced assets.
It also means that investors who do exhaustive research into
the details of the company should have lower diversification levels than
investors who rely on more quantitative approaches. If you believe that you
have found genuine mis-pricings because you understand specific companies
better than the market then it makes sense to hold enough of the shares of those
companies to take full advantage of those mis-pricings. However if you rely
heavily on heuristics like low P/E ratio or high Stockopedia StockRanks. then you capture the returns most consistently by being highly diversified. You
can be confident that as a whole group low P/E stocks will outperform, but
there is high uncertainty to which exact stocks in that group will drive that out-performance. Note that the research of Joel Greenblatt & Tobias Carlsisle shows that
investors are actually really bad at choosing which subset of ‘Deep Value’
investments really outperform! See Carlisle’s Investors @google talk for
details: https://www.youtube.com/watch?v=1r1vJZ80Z7I)
If you can find ways to reduce uncertainty by having greater
control over the companies you invest in then you can hold more a more concentrated
position. This is why it is rarely wrong for people like Buffett to have a
significant proportion of their funds in companies they own outright where they
can control the management and strategic direction of the business. As a pure
investor if a larger stake reduces diversification but enables you to
positively influence the management then this can be a good thing. However one
of the mistakes pure investors often make is holding a large position in their current
or former employer where they don’t have board level influence. This exposes
them to the combined risk of employment and concentrated investment. Loyalty is
not a good reason to be under-diversified, only superior knowledge or significant
influence is.
Principle 2 - Diversification levels should increase as the
consequences of making individual mistakes increases.
Diversification protects from an unexpected company or asset
specific event having a large negative effect on one’s wealth. Therefore it
makes sense not just to take account of how likely a negative event is to occur
but the consequences of it occurring. I am far more careful when walking along
a steep mountain ridge than walking across a field not because I regularly fall
over in either just that the consequence of doing so are far more serious in
the former. Likewise those who have large portfolios in comparison to their regular
income should be more diversified not because they are more likely to be wrong
just that the consequences of them being so are more severe.
This principle also leads one to consider liquidity in the
decision-making process. As one’s portfolio get’s bigger the ability to take
advantage of mis-pricings in smaller cap stocks may diminish since the risk of
a large holding in an illiquid stock is that you can’t get out if something
goes wrong. This factor may lead to higher diversification than would otherwise
be chosen in experienced investors.
Also as one’s wealth increases additional wealth has a
diminishing positive impact on one’s life, (what economists call diminishing
marginal utility.) So even excellent stock-pickers may choose to diversify into
other asset classes to reduce the risk that equities as an asset class suffer
extreme negative returns as they get wealthier.
Note that this principle can be in competition with the
first. When we begin our investing journeys we have much greater uncertainty in
our ability which should lead to higher diversification but we also usually start
with small sums relative to our future lifetime expected earnings which should
lead to lower. With these decisions there is no one correct level but a balance
of the unique factors that impact each of us.
Principle 3 – Err on the side of greater diversification
We all have behavioral biases. This means that you will
almost certainly be overconfident in your ability to pick stocks, overconfident
in the amount you truly know about each individual stock, and have hindsight
bias remembering your past successes with concentrated investing and forgetting
your mistakes. (Or at least engaging in attribution bias and blaming someone
else for their failure as an investment!) All of these mean that you will
underestimate the real level of uncertainty and underestimate the consequences
of mistakes. This may lead to lower diversification levels than would be
optimal. This doesn’t mean that everyone should hold a highly diversified
portfolio just that when you consider these things you should very consciously err
on the side of greater diversification not less.
So you can see that if like Buffet you are an experienced
investor that has a strong track record of identifying mis-pricings through
extensive analysis and taking influential stakes in those companies then high
levels of diversification is diworsification.
However if you are a relatively new investor relying on some
simple metrics to help you make investing decisions it probably wouldn’t harm
you to add a couple more stocks to your portfolio.
In my next post on portfolio construction I’ll introduce a
decision-making framework that can help you weight assets within your
portfolio.
No comments:
Post a Comment